Using derivatives to blunt the impact of a hawkish Fed
The Federal Reserve is clearly in tightening mode. Over the past year, the Fed has increased rates by 100 basis points, leading to sharp increases in not only LIBOR but also Treasury yields. Three-month LIBOR has increased from 1.30 to 2.40, and the ten-year Treasury recently crossed 3.2%, a level not seen in nearly seven years. We’ve seen this type of hiking cycle before, most recently in 2005, and even then many companies were negatively impacted with higher interest expense due to the prolonged tightening cycle. Today, many companies are turning to two main tools to address the impact of rising rates on their business: terming out debt with fixed rate bonds, and/or using derivatives to limit the impact of the rising rate environment.
Raising fixed rate debt
Many companies have continued to take advantage of the strong credit environment to raise fixed rate debt. Unfortunately, while an appealing strategy for many companies, this may not work for all. Issuing debt is a costly exercise, and not all companies can move to an all bond debt capital structure. As a result, many companies instead look to derivatives to hedge their floating rate debt and future financing.
Interest rate swaps
When considering using any interest rate derivative, companies should carefully consider a number of factors including business strategy such as mergers and acquisitions, expected debt pay-downs, and accounting implications. For companies with significant term loan debt as a part of their debt capital structure, interest rate swaps have become the most common tool for hedging against rising interest rates. Many highly leveraged companies aim to have at least 50% of their debt capital structure as fixed, with most aiming towards a ratio of 70-80% fixed, primarily through using swaps. Swaps tend to be relatively popular because they require no upfront premium, and synthetically convert floating rate debt into fixed rate debt. One major drawback with swaps is that they can be dilutive on near-term earnings when the yield curve is relatively steep. In other words, if a company is used to paying three-month LIBOR at 2.25% and the five-year swap rate is 3.00%, the marginal cost difference may be viewed negatively by senior management. One way to combat this negative perception is to remind the audience that three-month LIBOR won’t be staying at today’s level forever – just a few more rate hikes will negate the benefit of the lower rates.
Interest rate caps
An alternative that some companies may pursue to swaps is the purchase of an interest rate cap. Caps are not immediately dilutive to earnings in the same manner as swaps because they allow companies to benefit from lower rates in return for the payment of an upfront or ongoing annual premium. Caps tend to be far less popular than swaps primarily because of this payment, though derivatives accounting guidance allows for the premium to be expensed on a schedule over the life of the cap rather than impacting earnings upfront in the quarter in which the cap is purchased.
For companies with a greater portion of their debt capital structure based on fixed rate bonds, derivatives can still be used to hedge the refinancing or issuance of debt in the future. Investment grade companies looking to issue debt within three months may want to consider using treasury-based hedges such as treasury locks to hedge movements in the 10-year treasury yield. Should rates rise in the coming three months, the treasury lock will become an asset to the company in an amount sufficient to offset the increased interest expense from issuing in a higher rate environment. While the accounting treatment for such derivatives can be challenging, if applied correctly, companies can defer any such gains over the life of the financing such that interest expense is not negatively impacted from a rise in rates.
For companies worried about rising rates, interest rate derivatives are attractive solutions. Given the current rising rate environment, companies are considering not only hedging today’s debt but also hedging future debt and extending the maturity of existing hedges. All of these solutions involve significant analysis across financial, legal and accounting areas. Given the variety and complexity of approaches, an independent advisor can assist in evaluating the options.
Chatham Financial Corporate Treasury Advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit http://www.chathamfinancial.com/legal-notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions.
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